Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 31

Cost of Capital in Evaluating Mergers and Acquisitions

David Turf

Introduction

Mixed Results from M&A Transactions

Invest for Returns in Excess of the Cost of Capital

DCF Is the Best Corporate Decision Model

Focus on Cash Flows

Categories of Cash Flows

Estimating the Cost of Capital

Stand-Alone Cash Flows

Integration Cash Flows

Cash Flows from Synergies

Value and Price Differ

Impact of Recent Market Conditions

Contingent Consideration

Common Mistakes

Summary

INTRODUCTION

Accurate cost of capital estimation is critical to the sound evaluation of mergers and acquisitions (M&A) transactions. Finance literature is replete with studies indicating that many M&A transactions are failures for the acquiring company—with success or failure typically measured by either the return on investment relative to similar alternative investments or the creation or destruction of shareholder value.

M&A transactions can fail for a number of reasons, including difficulty in integrating systems, a culture clash between the target company and the acquirer, and poor business strategy. But perhaps the most straightforward reason is that the acquirer simply overpaid for the target company. While many factors can lead to paying too high a price for an acquisition, one common error is overvaluing the projected cash flows associated with the acquisition due to applying a discount rate (i.e., cost of capital) that is too low. Careful analysis can significantly reduce the possibility of this error. ...